Some people say Canadian house prices are about to experience a U.S.-style crash, even though indicators like the RBC Housing Affordability Measures show overvaluation is modest (except for a few areas, like Vancouver). They claim flaws in RBC’s methodology exaggerate affordability, so the measures should take second place to the price-to-income ratio and other indicators showing substantial overvaluation. I disagree with that view. Here’s why.
The 25% downpayment argument
One of the more comprehensive presentations of the bearish position is to be found in “Why housing affordability is a misleading indicator,” by Ben Rabidoux. His big claim is that RBC indicators overestimate affordability because they assume buyers make downpayments of 25%, when 5% (and consequently higher monthly mortgage payments) is now closer to the norm.
The problem with this statement is that it refers only to first-time homebuyers. But the homebuyer population also includes those homeowners who are buying a house to move to another location or a different type of house.
If this second group is factored in, a downpayment of 25% is a reasonable representation of the typical homebuyer. That’s because homeowners—by far the majority of households in Canada—have a substantial amount of equity they can bring to the purchase of a residential property.
In an interview with me, Robert Hogue, a senior economist with Royal Bank of Canada, said, “According to Statistics Canada’s numbers, Canadians hold a 67% equity stake in their residential properties. Therefore, we see little evidence that the ability of the existing-homeowner segment to bring in a substantial equity stake in the purchase of a residential property has deteriorated that much over time.”
Do RBC measures under or overestimate affordability?
Rabidoux also mentions the RBC measures have other “flaws” that contribute to the overestimation of affordability. But if one looks closely at the data, a case can be made that the RBC measures may actually underestimate affordability—depicting houses as more expensive than they really are. Of note, they assume buyers take out 25-year amortizations when 30-year amortizations (and lower monthly payments) are currently permitted.
To their credit, Rabidoux and other critics do mention this offsetting factor. What is odd is their failure to mention another important offset: the RBC indexes assume buyers pay posted, 5-year, fixed-mortgage rates (mortgage rates were predominantly of this kind when the indexes began). Such rates will generally be higher than what home buyers currently pay, not only because banks now offer substantial discounts from posted rates, but also because many buyers (40% according to a July 2011 TD Bank report) take mortgages with variable rates, which are lower than fixed rates at least 85% of the time.
The use of posted rates alone could be quite significant and swamp other factors. “Our use of posted mortgage rates, as opposed to market rates, in the calculation of affordability leads to a significant underestimation,” Hogue said. “And this ‘bias’ has become much more of a factor over time—discounts from the posted rates have increased quite noticeably since the late 1990s.”
In fact , there are a variety of factors at play within the RBC indicators and it would appear nothing definitive can be said of the net bias until an empirical study (comparing various analytical indexes) is performed and published. In the interim, neither housing bears nor bulls would seem to be in a position to make conclusive claims on how reliable the measures are.
One thing may be said, however. When it comes to making statements about the future direction of house prices, the ratio of house prices to income and other indicators favoured by the housing bears appear to constitute less reliable signals. By leaving out mortgage rates, they omit a major component of the ability to pay, a key driver of house prices. How can forward-looking statements on house prices be made based on a model that excludes a main determinant of house prices? The inclusion of mortgage rates in the RBC measures may be imperfect, but at least there is an accounting for this vital element.
The risk of rising interest rates
At this juncture the housing bears may argue that it is imprudent to use RBC affordability measures given interest rates are low and most likely to go up. But interest rates normally trend upward when there is growth in incomes and jobs, factors that add to housing demand and offset the rate rises.
About the only time interest rates pose a substantial risk of precipitating a crash is when central banks become concerned about overheating in the economy and are willing to provoke a recession to cool things off. This was, in fact, the catalyst that pricked the U.S. housing bubble in 2007.
In Canada, and around the world, such a catalyst is absent as of 2012. Indeed, monetary policy is hyper-expansionary, making it difficult to see any kind of a Canadian housing crash on the horizon.
A few years down the road, there may come a time when the monetary cycle turns hostile, but there is no telling that far in advance if overvaluation will be so extreme that the inevitable outcome is a housing meltdown. Some of the possible excess in house prices could in the interval be tempered by factors such as income growth, regulatory changes and modest price corrections along the way.